Choosing an Entity Structure for Your New Business Under the 2018 Tax Law
If you are starting a new business, choosing an entity structure is an essential first step that can set you up for success or can trip you up further down the road. It's important to consider which entity structure best suits your business as it is now and how it will be in the future. Which entity structure you choose can impact how many shareholders or partners you are allowed to involve, how equity is structured, how the business should be controlled and managed, and how vulnerable the owners' personal assets may be to liabilities associated with the business. Under the new tax law, the Tax Cuts and Jobs Act (TCJA), there are also serious tax implications that come with choosing an entity structure. It will be important to consider both which structure reflects your business needs and which will minimize your tax burden
Incorporating Your Business with the State
There is no federal registration of business entities. You will first need to incorporate or organize in the state where you will do business, and the rules for different entity structures will be state-specific. There are many more business entity structures than those outlined in this post, but this can give you a starting idea of the most common entity structure options
Sole Proprietorship and General Partnership
A sole proprietorship is the simplest form of business entity. There are no forms to fill out, and you do not file with the state to become a sole proprietor. Instead, the state will consider you to be a sole proprietor if you are an individual doing business. Although this is the easiest way to start doing business, because it allows you to move your own assets in and out of business as needed, it isn’t necessarily the safest structure. Sole proprietors have no liability protection, meaning you, as the owner, can be held personally responsible for the debts and obligations of the business.
A general partnership is as easy as a sole proprietorship - it’s just two or more people doing business. Again, there is no formal process of registration. Under a general partnership, all partners are jointly and severally liable for the obligations and debts of the business.
Limited Liability Partnership (LLP)
A limited liability partnership is a similar structure to the general partnership, except that it requires registering with the state. By registering, the partnership gains some protection and separation from the entity’s liabilities. Under a limited liability partnership, partners can also shield themselves from one another’s bad actions.
Limited Liability Corporation (LLC)
The LLC is the most popular business entity. It offers the liability protection of a corporation while remaining relatively simple. An LLC is controlled by members, rather than shareholders. To create an LLC, you must register with the state and file annual reports, but the documentation burden is less than a regular corporation. LLCs can choose to be taxed as a corporation or as a pass-through entity on the members' individual tax returns. A single member LLC is treated as a disregarded entity. While the member still retains the benefits of liability protection, the income is taxed as if it was direct income to the individual member.
C Corporation (C-Corp)
A C-Corp is what you likely think of as a typical business. It is owned by shareholders, who hold stock certificates or shares. The corporate entity acts as a liability shield for individual shareholders; they are not responsible for the debts, actions, or obligations of the company. C-Corps are taxed independently from the shareholders, creating what some call "double taxation." This means that the corporation pays taxes on the income it makes. Then, it distributes the profits to its shareholders in the form of dividends, where the dividends are taxed at the individual shareholders' rates.
S Corporation (S-Corp)
An S-Corp isn't an entity structure; rather it's a tax election. Another entity, such as a C-Corp or LLC, can elect to be taxed as an S-Corp. This means that the company can be treated as a pass-through entity. S-Corp small businesses may also pay reasonable compensation to owners and then treat the remainder of profit as a distribution. Because distributions are not subject to payroll taxes, this can result in significant tax savings. In exchange for the tax benefit, there are some restrictions on S-Corps. They can only have one class of stock, and may only have a limited number of shareholders. Failure to comply with the requirements of an S-Corp means that the entity will revert to a C-Corp for tax filing.
How Will Your New Business Be Taxed Under the New Law?
The TCJA was presented to the American public as a business-friendly, economy-boosting tax plan. To this end, there are some new tax benefits allotted for corporations. The TCJA divides businesses into two groups: corporations and pass-through entities. Each of these two groups is subject to different rules regarding taxation.
Under the TCJA, all corporations will now pay a flat 21% tax rate. This is significantly lower than the 2017 rates, which could be as high as 35%. When you are choosing which structure to use for your new business, this lower tax rate may be desirable. Most deductions for corporations have also been preserved in the new tax law, unlike the deductions that used to be available to employees. It is important to remember that C-Corps, that pay the 21% tax rate, are also subject to more intensive reporting requirements and the potential "double taxation" issue discussed above.
LLCs, S-Corps, and other pass-through entities will not receive the corporate tax cut. Instead, income to a pass-through entity is taxed at the personal rate of the member/owner/shareholder. You will want to take a look at the adjusted personal income tax brackets to see how your personal tax rate may have changed under the TCJA. Despite being taxed at the personal rate, income from a pass-through entity may be subject to s 20% business income deduction.
There are some restrictions to the 20% deduction based on what kind of business you own and how much income you and your spouse bring in. For any kind of business organized as a pass-through entity, there are threshold earnings limits of $157,500 for a single filer and $315,000 for those who file jointly. Taxpayers that earn less than these threshold limits will be eligible for the full 20% deduction, regardless of the kind of business they perform.
Businesses that involve the performance of services where the main asset of the business is the reputation of one or more owners/employees, the new tax law considers a "professional services" business. Examples of professional service providers include lawyers, consultants, architects, and financial advisors. If you fall into the category for professional services, and your income exceeds the threshold amounts, you may lose the deduction benefit. For earnings within the range of $50,000 above the threshold for single filers and $100,000 for joint filers, the deduction phases out from 20% to 0%. Taxpayers who own pass-through professional services businesses and have an income exceeding the allowed range (up to $207,500 for single filers and $415,000 for couples) will not be eligible to take the deduction at all.
If you own a pass-through entity that does not qualify as a professional services business, there is another formula to consider: businesses that surpass the threshold earnings limits will see their deduction limited to the greater of 50% of total wages paid OR 25% of total wages paid PLUS 2.5% of the cost of tangible depreciable property, such as real estate.
Ask for Help
The benefits for pass-through entities under the new tax law are not simple, and your particular situation may create results that you do not expect. When choosing a business entity and electing how you want that business to be taxed (as a pass-through entity or as a corporation), there will be a lot to consider. Consult with an attorney and a tax professional to determine which is the best choice for you and your new business. Contact Faulkner Law at (770) 685-9501 to do a full analysis of how this bill will impact you and your business.